Tokyo thoughts turn to euro

Good news and bad newsIMF fault lines with Germany

by David Marsh

Mon 15 Oct 2012

Plenty of people at the weekend Tokyo IMF/ World Bank meetings said they want a durable solution to the crisis in economic and monetary union (EMU). And there are some signs that Europe may be slowly turning the corner. But as long as doubt persists on whether the euro area’s cessation of hostilities will hold, so will the uncertainty overhanging the world economy.

A large fault line in EMU runs through Germany, which the IMF openly blames for not having alleviated far earlier the vicious circle of low euro area growth and persistent imbalances.

The European Central Bank, on the other hand, emerged from the meetings with its reputation intact. An important point underlined by ECB president Mario Draghi, and backed by key governing council members such as Austria’s central bank governor Ewald Nowotny, is that the ECB has to remain distant from bargaining over whether the Spanish government will apply to European governments (and the IMF) for a new bail-out programme.

Conditionality is necessary so that errant-but-reforming states ‘do not take the money and run’. But before the ECB can decide whether countries Spain can tap its so-far-unused OMT facility to buy state bonds, the conditionality has to be applied by lending governments, not the ECB.

In two important aspects, decision-makers from both emerging market and developed economies were in agreement. First, the good news. Euro member states have made important strides in fiscal and structural reforms, productivity gains, establishing mutual-assistance credit mechanisms and laying the groundwork for better economic governance and financial surveillance. Spain and Greece both ran current account surpluses in July. A senior Japanese policy-maker gives Europe ‘nine out of 10 for effort’ in trying to rectify the mistakes of the first 10 euro years.

Next, the bad news. Positive economic changes have been achieved largely at the cost of sharp increases in unemployment and a reduction in social welfare in the most-affected peripheral countries. This has damaged political and social cohesion and throws into doubt whether the edifice is sustainable.

One sign of a reduction in stress in Europe, highlighted by key euro officials in Tokyo, has been an unusually large fall in the Bundesbank’s claims on the ECB under the Target-2 interbank payments system. However, the 7.5% fall in September to just under €700bn still leaves Germany’s Target balance 50% higher than at the start of 2012.

That’s why it’s vital for the euro’s future that recent signs of capital reflow into countries like Spain are maintained. Asian central banks, major state funds, and other large institutional investors are still holding back from large-scale euro commitments, leaving short-term speculators as well as (potentially) official European creditors to shoulder the burden. As a leading Japanese investor puts it: ‘Once confidence [in the euro] is lost, it’s difficult to recover.’ So this will be a long haul.